Measuring the Cost of Living Copyright©2004 South-Western Measuring the Cost of Living • Inflation refers to a situation in which the economy’s overall price level is rising • The inflation rate is the percentage change in the price level from the previous period Copyright©2004 South-Western THE CONSUMER PRICE INDEX • The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer • The Bureau of Labor Statistics reports the CPI each month • It is used to monitor changes in the cost of living over time Copyright©2004 South-Western THE CONSUMER PRICE INDEX • When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living Copyright©2004 South-Western How the Consumer Price Index Is Calculated • Fix the Basket: Determine what prices are most important to the typical consumer • The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys • The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services Copyright©2004 South-Western How the Consumer Price Index Is Calculated • Find the Prices: Find the prices of each of the goods and services in the basket for each point in time Copyright©2004 South-Western How the Consumer Price Index Is Calculated • Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times Copyright©2004 South-Western How the Consumer Price Index Is Calculated • Choose a Base Year and Compute the Index: • Designate one year as the base year, making it the benchmark against which other years are compared • Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100 Copyrightâ2004 South-Western How the Consumer Price Index Is Calculated Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period Copyright©2004 South-Western How the Consumer Price Index Is Calculated • The Inflation Rate • The inflation rate is calculated as follows: CPI in Year - CPI in Year Inflation Rate in Year =  100 CPI in Year Copyright©2004 South-Western The GDP Deflator versus the Consumer Price Index • The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the BLS change the basket) • …whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year Copyright©2004 South-Western Figure Two Measures of Inflation Percent per Year 15 CPI 10 GDP deflator 1965 1970 1975 1980 1985 1990 1995 2000 Copyright©2004 South-Western Copyright©2004 South-Western CORRECTING ECONOMIC VARIABLES FOR THE EFFECTS OF INFLATION • Price indexes are used to correct for the effects of inflation when comparing dollar figures from different times Copyrightâ2004 South-Western Dollar Figures from Different Times Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 2001: Salary2001 Price level in 2001  Salary1931  Price level in 1931 177  $80,000  15.2  $931,579 Copyright©2004 South-Western Table The Most Popular Movies of All Times, Inflation Adjusted Copyrightâ2004 South-Western Indexation When some dollar amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation Copyrightâ2004 South-Western Real and Nominal Interest Rates Interest represents a payment in the future for a transfer of money in the past Copyright©2004 South-Western Real and Nominal Interest Rates • The nominal interest rate is the interest rate usually reported and not corrected for inflation • It is the interest rate that a bank pays • The real interest rate is the nominal interest rate that is corrected for the effects of inflation Copyright©2004 South-Western Real and Nominal Interest Rates • You borrowed $1,000 for one year • Nominal interest rate was 15% • During the year inflation was 10% Real interest rate = Nominal interest rate – Inflation = 15% - 10% = 5% Copyright©2004 South-Western Figure Real and Nominal Interest Rates Interest Rates (percent per year) 15 10 Nominal interest rate Real interest rate –5 1965 1970 1975 1980 1985 1990 1995 2000 Copyrightâ2004 South-Western Summary The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year • The index is used to measure the overall level of prices in the economy • The percentage change in the CPI measures the inflation rate Copyrightâ2004 South-Western Summary The consumer price index is an imperfect measure of the cost of living for the following three reasons: substitution bias, the introduction of new goods, and unmeasured changes in quality • Because of measurement problems, the CPI overstates annual inflation by about percentage point Copyrightâ2004 South-Western Summary The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed • In addition, the CPI uses a fixed basket of goods, while the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes Copyrightâ2004 South-Western Summary Dollar figures from different points in time not represent a valid comparison of purchasing power • Various laws and private contracts use price indexes to correct for the effects of inflation • The real interest rate equals the nominal interest rate minus the rate of inflation Copyright©2004 South-Western ... Consumer Price Index and the Inflation Rate: Another Example • • • • • Base Year is 20 02 Basket of goods in 20 02 costs $1 ,20 0 The same basket in 20 04 costs $1 ,23 6 CPI = ($1 ,23 6/$1 ,20 0)  100 = 103... between 20 02 and 20 04 Copyright 20 04 South-Western CPI components 20 15 -20 20 period No of items in CPI: 654 Copyright 20 04 South-Western Problems in Measuring the Cost of Living • The CPI is an... Copyright 20 04 South-Western How the Consumer Price Index Is Calculated • The Inflation Rate • The inflation rate is calculated as follows: CPI in Year - CPI in Year Inflation Rate in Year =  100 CPI